Main impact of QE3 withdrawal will be in Europe

Commentary: Normalization of rates will leave Europe exposed

LONDON (MarketWatch) — Surely you weren’t surprised. The gradual unwinding of the Federal Reserve’s extraordinary asset purchases as the U.S. economy slowly recovers has been one of the best-followed interest-rate events in monetary history.

For many months, U.S. monetary officials, speaking in private, have been expressing concern about possible collateral damage that could be wrought by future quantitative easing (QE) dismantling, including the effect on the value of banks’ holdings of bonds. Investors who say they’ve been caught out over all this no doubt are vaguely astonished when it gets dark in the evening or when the sun rises in the morning.

Outside of U.S. markets, the main impact up to now of real and prospective U.S. monetary tightening has been seen in the withdrawal of liquidity from emerging market economies, with countries as varied as Brazil, Turkey and Indonesia in the firing line — developments which have not been helped by social unrest in the first two countries.

But wider repercussions are likely across the euro
EURUSD, +0.1194%
area, which is still a large-scale accident waiting to happen on account of highly disparate economic developments in the 17-nation bloc and the prospect of rising financial market nervousness ahead of the German elections on Sept. 22.

AFP/Getty Images

Federal Reserve Chairman Ben Bernanke hinted last week that the Fed’s QE3 quantitative easing program could be gradually ended. Europe will feel the impact of Bernanke’s decision.

On numerous occasions in the past 30 or 40 years, American monetary tightening has had a negative impact on various European exchange-rate regimes; the same is true of German elections, which in the past were often the trigger for European exchange-rate realignments. Under monetary union, such adjustments of course cannot take place. But a combination of both sets of circumstances could bring a bumpy ride, contrasting with Chancellor Angela Merkel’s wish for maximum summertime euro calm to help secure her hold on power.

The prospective U.S. tightening underlines the complexity of world economic management given great heterogeneity in different groups of countries’ economic performance. Europe remains mired in diversity with euro-bloc states collectively bumping along the bottom and no sign of sustainable growth in recession-hit debtor nations.

Normalization of U.S. interest rates — although generally a welcome sign of the robustness in the world’s largest economy — accompanies disturbing signs of slower growth in China and other now-less-dynamic developing countries. Developing-nation economic leaders such as Guido Mantega, Brazil’s outspoken finance minister — who two years ago accused the U.S. of launching “currency wars” through QE and a lower dollar, allegedly to steal a growth advantage — have had to change their tune.

The bull run in peripheral European bonds promoted by the European Central Bank’s much-hyped but unused OMT bond-buying program has juddered to a halt. This makes an OMT application by a distressed euro member slightly more likely, but hardens further the conditions (including German hostility) under which such outright monetary transactions could be drawn. I still think the OMT will go down in history as a splendid psychological coup that was never implemented.

Apart from signs of wrangling over topping up official credit programs for Greece and Cyprus, there have been other signs of strain in the last few days. European Union finance ministers failed to clinch an accord on new rules for bailing out European banks after nearly 18 hours of negotiations early Saturday morning, although no doubt some sort of compromise will be hammered out next week.

The European Investment Bank rejected the notion that it could put together charge-scale securitization packages for loans to medium-sized enterprises, scotching a suggestion by Mario Draghi, the European Central Bank president, that the EIB could somehow ride to the rescue.

The basic problem besetting Europe is lack of growth. Signs of buoyancy from across the Atlantic should be welcome in the Old Continent. Unfortunately, the beneficial aspects are likely to fade into the background. American interest-rate tightening will expose the true state of European vulnerability that had previously been covered up by a wave of central banking liquidity.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.